What can financial advisers expect to see in a portfolio?

13 October 2014

Jason Baran - Insight Analyst (Investments)

With their history of servicing the high-net-worth client segment, DFMs have gained broad knowledge of investments over the years. This makes them a viable outsourcing option for financial advisers.

Why advisers choose DFMs

Their larger portfolio sizes have enabled many high-net-worth individuals to invest in a wide array of assets and add meaningful allocations to more specialised investments. Due to inheritance planning, a more refined approach to portfolio construction has been used for this segment, rather than a mainstream broad brush approach.

Now that suitability and quality of advice have been brought to the fore, many advisers consider outsourcing their portfolio construction to DFMs with their experience.

It’s important to remember though that when outsourcing, the adviser isn’t absolved of their final responsibility to a client. Advisers still need to understand the underlying investments being used and make appropriate recommendations. The adviser needs to be in a position to explain the investment risks to the client.

The typical portfolio

Typically, advisers invest in a range of multi-asset funds provided by the DFM, usually ranging from a lower-risk ‘defensive’ portfolio to a higher-risk ‘growth’ or ‘opportunities’ portfolio. As with modern portfolio theory, the understanding is that the higher risk implies a higher return in the long term.

Within the portfolio range, there will be common underlying investments. They usually include fixed income (bonds) or global equities. There will also be exposure to property, private equity and hedge funds. The purpose of this wide array of assets is to maximise diversification.

Typical asset classes

The table provides more information on the assets used in typical portfolios.

AssetTypical annual volatilityRisk levelSummary

Money market, ie cash

0-2%

Low

The lowest risk form of investment, usually in the form of short-term maturity deposits, ie up to six months. Can also mean cash in other foreign currencies, but obviously this is riskier due to FX rate risk.

Bonds and fixed income

5-15%

Low to high

Investments in either government or corporate bonds worldwide, ranging from the safest investments in US government bonds to those in emerging market companies, which carry much higher risk.

Equities

10-25%

Medium to very high

Investments in companies or a basket of companies via an index. Geographically ranging from the large mature markets of the US, UK, Europe and Japan to emerging markets and now also ‘frontier’ markets (such as Myanmar and Mongolia) – the latter of which can be very high risk – but also while offering higher diversification. Investments may be made via ‘actively’ managed funds which try to beat a benchmark, or passives that charge lower fees but aim only to track a benchmark.

Property

10-25%

Medium to very high

Investments in different types of property worldwide. Can be made via direct investments, or those in pooled vehicles, such as a real estate investment trust (REIT). Can offer good diversification, but also come with increased liquidity risk due to the size and costs of divesting investments, particularly during a market slump.

Hedge funds

10-30%

Medium to very high

Involves a wide range of risk levels as hedge fund strategies can involve a very wide range of investments and derivatives. Hence, due diligence and your understanding of each particular hedge fund set-up are vitally important. Also, you need to be aware of the fees involved, as these can be very high and involve a performance-related fee.

Commodities

15-30%

Very high

Ideally, this should involve direct investments in commodities or commodity futures so that your client can gain the greatest benefits from diversification. This can also be an investment in an index tracker, the Rogers International Commodity Index for example. Investments in commodity funds can sometimes come in the form of equity funds in commodity companies (eg BP, Rio Tinto, BHP Billiton). This is less ideal as they offer greatly reduced diversification compared to the direct commodity investments, and are more correlated with general equity markets.

Private equity

15-30%

Very high

Private equity investments involve equity stakes in companies that aren’t traded on public stock exchanges. Frequently, this involves public companies that have hit trouble and are undergoing a turnaround after being taken private. Risks can be high due to the lack of liquidity and frequently such companies have high levels of debt.

 

Note: Volatility as stated is based on the statistical definition of annualised standard deviation. In basic terms, you could expect the potential range of returns to be within the stated volatility range two thirds of the time, after a year.

The following charts give an example of asset weights in low, medium and high risk multi-asset funds:

A solution but no delegation of responsibility

As markets have matured and become more sophisticated, the range of assets available to investors has increased. A DFM-provided ‘outsourcing’ solution can make sense, but it’s important to remember that the adviser must understand these investments and how they work together. Ultimately, it’s the adviser who carries fiduciary duty to clients.

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